Net operating income, the way lenders underwrite it.
Net operating income is what a property earns after operating expenses and before debt service. Enter gross potential rent, other income, vacancy, operating expenses, a management fee and replacement reserves to see effective gross income, NOI and the expense ratio, built the way a lender underwrites it rather than the way a sale flyer presents it.
- Vacancy and credit loss
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- Effective gross income
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- Management fee
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- Total expenses incl. reserves
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- Expense ratio
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How to calculate NOI
Start with gross potential rent, the rent if every unit were leased at its contract or market rate. Add other income such as parking, fees and expense reimbursements. Subtract vacancy and credit loss to reach effective gross income. Then subtract operating expenses: taxes, insurance, utilities, repairs, payroll, a management fee and replacement reserves. What is left is net operating income.
Debt service, depreciation, income taxes and capital expenditure are not operating expenses and never enter NOI. That is what makes NOI comparable across properties with different owners and loans.
A worked example
A property has $1,200,000 of gross potential rent and $50,000 of other income. At 5 percent vacancy and credit loss, effective gross income is $1,187,500. Operating expenses are $400,000, a 3 percent management fee on EGI adds $35,625, and replacement reserves are $30,000. NOI is $721,875 and the expense ratio is 39.2 percent.
| Line | Amount |
|---|---|
| Gross potential rent | $1,200,000 |
| Other income | $50,000 |
| Less vacancy and credit loss (5%) | ($62,500) |
| Effective gross income | $1,187,500 |
| Operating expenses | ($400,000) |
| Management fee (3% of EGI) | ($35,625) |
| Replacement reserves | ($30,000) |
| Net operating income | $721,875 |
Lender NOI vs the seller's NOI
A seller's or broker's NOI is often the in-place figure with no vacancy, no management fee because the owner self-manages, and no reserves. A lender's underwritten NOI adds all three, using market vacancy, a market management fee and per-unit or per-square-foot reserves. The gap can change the loan amount, since every sizing test, DSCR, debt yield and value, starts from NOI.
Lenders also reconcile NOI to the trailing twelve months of actual operating statements and to the rent roll, and question any line that the pro forma grows faster than history supports.
What NOI feeds next
NOI divided by value is the cap rate. NOI divided by the loan is debt yield. NOI divided by annual debt service is DSCR. Carry the result straight into the cap rate, debt yield and DSCR calculators.
Questions lenders ask
- What is the formula for NOI?
- NOI equals effective gross income minus operating expenses. Effective gross income is gross potential rent plus other income, minus vacancy and credit loss.
- Does NOI include the mortgage payment?
- No. Debt service is paid out of NOI, not deducted to reach it. That keeps NOI comparable across properties with different financing.
- Are replacement reserves included in NOI?
- Lenders and appraisers usually deduct replacement reserves when underwriting NOI. Sellers often leave them out. Check which convention a figure uses before comparing.
- Why do lenders charge a management fee on a self-managed property?
- Lenders usually underwrite a market management fee as a percentage of effective gross income even when the owner self-manages, so the NOI holds up if a third-party manager is ever needed.
- Is NOI the same as cash flow?
- No. Cash flow is what remains after debt service and capital spending. NOI is the figure before them.
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